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EMPLOYEE BENEFITS
ALERT
DEFERRED COMPENSATION UNDER 409A:
Focus on Issues: Equity-Based Compensation
JUNE 2007
Equity-based compensation refers to grants of stock rights (which are
nonqualified stock options and SARs), statutory stock options and
restricted stock to employees, directors, consultants or other service
providers, including similar equity-based incentives issued by
partnerships. Equity-based compensation may be exempt from 409A
coverage if certain exemption criteria are satisfied. If all such criteria
are not satisfied, equity-based compensation will be subject to the
general principles and limitations set forth in the 409A rules and
summarized in our previous Alerts. Also, modification of stock rights
after grant could bring otherwise exempt stock rights within the scope
of 409A.
This bulletin is published as a service to
clients and others interested in
employee benefits issues.
The
information provided herein is general
in nature and should not be relied upon
as legal advice as to specific factual
situations. If you have any questions or
require assistance in evaluating or
modifying existing plans, please contact
one of the members of the Employee
Benefits Practice Group.
Consequently, plans, arrangements and related practices regarding
equity-based compensation should be promptly examined to determine
if they currently comply with, or are otherwise exempt from, 409A. If
not, then they should be reviewed to determine if they can be revised
to avoid penalties potentially triggered by 409A violations.
Employee Benefits Practice Group
Reminder - Transition Relief: The 409A rules provide a variety of
planning opportunities, including the ability to change the timing of
various payments, that are only available if implemented during the
transition period that ends on December 31, 2007.
James E. Earle
704.331.7530
Sally W. Higgins
704.331.7510
Allyson B. Lavins
704.331.7573
Kiran H. Mehta
704.331.7437
Lee West Movius (Chair)
704.331.7435
John Nestico
704.331.7529
Raleigh A. Shoemaker
704.331.7457
Glossary: Please refer to the attached glossary for key terms and
concepts used in this and subsequent Alerts on 409A.
Mary Turk-Meena
704.331.7590
Michel P. Vanesse
704.331.7464
The final 409A regulations require full operational
compliance and documentation by December 31, 2007.
Lynne S. Wakefield
704.331.7578
Caroline E. Wainright
704.331.7483
Emily Zimmer
704.331.7405
Founded in 1957, Kennedy Covington is one of the largest law firms in the Carolinas with offices
in Charlotte, Raleigh, Research Triangle Park, Columbia and Rock Hill. Our more than 200
attorneys use their diverse experience and knowledge to counsel clients in varied industries
such as banking and finance, real estate, technology and manufacturing. At Kennedy
Covington, we give more than a legal opinion; we provide a business perspective.
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Exemption for Stock Rights
·
Stock rights generally are exempt from 409A if:
·
the option or SAR is not in-the-money at grant;
the option or SAR is only exercisable for or with respect to "service recipient stock"; and
the option or SAR does not include any feature to defer compensation beyond the date on
which the option or SAR is exercised or, if later, the date on which the acquired stock
becomes substantially vested.
For purposes of determining whether a stock right is in-the-money at grant, the 409A rules provide
guidance for valuing the underlying stock. Taxpayers should carefully document the valuation
method used in determining the exercise price of stock rights. The permissible valuation methods
depend on whether the stock is readily tradable on an established securities market.
-
For stock readily tradable on an established securities market, the 409A rules generally use
the trading price of the stock over certain time periods to determine fair market value.
For stock not readily tradable, the 409A rules provide that fair market value is a "value
determined by reasonable application of a reasonable valuation method." The 409A rules
also provide presumptions in favor of the taxpayer if certain valuation methods are used to
value the stock.
·
Generally, stock is treated as "service recipient stock" only if such stock (i) is treated as common
stock for purposes of Code Section 305, (ii) does not include any distribution preferences other than
in liquidation, and (iii) is not subject to certain mandatory repurchase obligations, puts or calls at
other than fair market value. Any grants of stock rights with respect to any stock other than
traditional common stock should be closely evaluated.
·
Stock rights that are not exempt from 409A must comply with 409A to avoid the penalties
summarized in our previous Alerts. Stock rights generally will not comply with 409A unless the
time at which such stock rights can be exercised is limited to permissible distribution events under
409A.
·
Caution should be exercised in modifying the terms of any existing stock rights. A modification
that may provide the holder with a direct or indirect reduction in exercise price is generally treated
as the grant of a new stock right. Such new grant will then have to be retested using the above
criteria to determine if such stock right is exempt from 409A. Extending the time during which a
stock right can be exercised may cause such stock right to be treated as having an impermissible
deferral feature.
·
409A imposes strict limitations on substituting stock rights of one corporation for stock rights of
another corporation in connection with corporate acquisition and other transactions.
·
Until further IRS guidance is provided, the principles applicable to stock rights described above
apply to equivalent rights with respect to partnership interests.
Exemption for Statutory Stock Options
·
Generally, incentive stock options and options granted under a tax-qualified employee stock
purchase plan are excluded from 409A.
·
The exemption for statutory stock options does not apply to a modification, extension or renewal of
a statutory stock option treated as the grant of a new option that is not a statutory stock option.
Exemption for Restricted Stock
·
Grants of restricted stock generally are excluded from 409A.
·
However, restricted stock "units," phantom stock and other forms of deferred delivery of shares may
provide for a deferral of compensation under 409A. These types of plans should be closely reviewed.
·
Until further IRS guidance is provided, a partnership's issuance of a capital or profits interest should
also qualify for exemption from 409A.
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409A Glossary
alternative method election requirements
The following requirements, which must be satisfied for an alternative method of identifying specified
employees to be effective under the 6-month delay rule: (1) the alternative must be used for identifying
specified employees under all plans subject to 409A, (2) the alternative must be specified in each plan
subject to 409A or in a separate policy document applicable to all 409A plans, and (3) all corporate action
necessary to make the alternative binding on all 409A plans must have been taken.
employer
For purposes of determining whether an employee has experienced a separation from service, all entities
within a controlled group of companies based on a 50% ownership standard, unless a different percentage
is selected within certain limits.
legally binding right
A contractual or other right that is enforceable under applicable law, even if conditioned on future services
or events. A purely discretionary arrangement does not constitute a legally binding right.
key employee / specified employee
A "key employee" is (A) an officer of the company with annual compensation of $145,000 or more (indexed,
and limited to the top 50 employees), (B) a 5% owner, or (C) a 1% owner with compensation greater than
$150,000. A "specified employee" is an employee who, as of the date of the employee's separation from
service, is a "key employee" of a company whose stock is publicly traded.
performance-based compensation
Compensation for which the amount of, or right to, payment must be contingent on the satisfaction of preestablished individual or organizational criteria over a performance period of at least 12 consecutive
months, the outcome of which is substantially uncertain.
separation from service
In the case of an employee, upon the permanent reduction of usual service provided to the employer for
the preceding three years to a level that is no more than 20% of the employee's pre-termination service
level, unless the employer expressly designates a different percentage (but not more than 50%); and in
the case of an independent contractor, upon the good faith and complete termination of the contract.
separation pay
Any compensation that will not be paid under any circumstances unless the employee has had a separation
from service (voluntary or involuntary); includes cash payments, reimbursements of expenses, and in-kind
benefits (such as continuation of perquisites and fringe benefits).
short-term deferral / short-term deferral period / 2½ month rule
Payment of compensation must be and is made within 2½ months after the later of the end of the
employer's or employee's taxable year (whichever is later) in which the legally binding right first arose or
if later, in which the legally binding right is no longer subject to a substantial risk of forfeiture.
6-month delay rule
"Specified employees" generally may not receive payment of deferred compensation upon their separation
from service before the date that is 6 months after their separation from service or, if earlier, their death.
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stock right
A stock option (other than an Incentive Stock Option described in Code Section 422 or an option granted
pursuant to an employee stock purchase plan described in Code Section 423) or a stock appreciation right
(SAR).
substantial risk of forfeiture
(1) A payment is conditioned on (A) the performance of substantial future services (i.e., time-based
vesting) or (B) the occurrence of a condition related to a purpose of the compensation (i.e.,
performance-based vesting); and
(2) the possibility that the payment may be forfeited is substantial.
In general, a substantial risk of forfeiture exists if the employee forfeits compensation in case of a voluntary
resignation or retirement, even if the compensation would vest in case of an involuntary termination.
12-month 5-year rule
A deferred payment may be re-deferred if:
(1) the election to re-defer is made at least 12 months before the scheduled payment date; and
(2) the new payment date is at least 5 years after the scheduled payment date.
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